Over the past five years, top regional airline SkyWest (NASDAQ: SKYW) has achieved a remarkable comeback. In 2014, the company was barely profitable, due to a combination of unfavorable weather, rising pilot costs, and the poor profitability of its ExpressJet subsidiary. SkyWest posted a full-year adjusted profit of less than $7 million -- on more than $3 billion of revenue -- for 2014.
However, SkyWest has rapidly expanded its profit margin since then. And while it will be harder to wring out efficiency gains going forward, SkyWest has other options for keeping earnings per share moving higher in the next few years.
A margin-fueled recovery
Last week, SkyWest reported that EPS reached $5.30 in 2018, up from just $0.14 in the trough year of 2014. Yet the company's revenue has barely budged in recent years. SkyWest generated $3.22 billion of revenue in 2018, down fractionally from $3.24 billion in 2014.
This remarkable margin recovery was driven by SkyWest shifting its fleet away from turboprops and cramped 50-seat jets in favor of spacious 70- to 76-seat regional jets, primarily the Embraer (NYSE: ERJ) E175. Embraer's E175 has become the regional jet of choice for the U.S. legacy carriers -- i.e., SkyWest's partners -- because unlike most regional aircraft, it provides a passenger experience comparable to mainline jets. SkyWest had 146 E175s in its fleet by the end of 2018, up from zero five years earlier.
An Embraer E175. Image source: United Airlines.
As a result, SkyWest has been able to hold revenue flat even though it has shrunk its fleet from 755 aircraft at the beginning of 2014 to fewer than 600 planes in 2018. SkyWest's surging EPS can be traced directly to its dramatic increase in revenue per aircraft over the past several years.
SkyWest will need new sources of earnings growth
Last month, SkyWest sold its perennially unprofitable ExpressJet subsidiary, reaping a small cash windfall and removing a big source of risk. This will provide a small earnings lift in 2019. The deal also gives SkyWest priority for adding another 25 regional jets at United Continental -- which would most likely be E175s -- but only if United decides to increase its fleet of large regional jets.
In the meantime, SkyWest has firm plans to add just 12 more Embraer E175s to its fleet over the next three years. Furthermore, most of those planes will replace CRJ900s, which are also relatively profitable to fly. Thus, SkyWest has pretty much reached the end of the fleet transition that has driven most of its earnings growth since 2014.
The benefit of stability
While the introduction of the Embraer E175s has been a huge profit driver for SkyWest in recent years, the fleet transition has been expensive. Capital expenditures have averaged nearly $1 billion annually since 2015. This has driven SkyWest's net debt up from less than $1 billion five years ago to around $2.5 billion today.
By contrast, with only a dozen E175 firm orders on the books, SkyWest's capex is set to decline radically. As things currently stand, total capex for 2019 and 2020 combined will be less than $500 million.
Meanwhile, SkyWest's annualized operating cash flow has recently surpassed $700 million. This means it will be able to rapidly reduce its debt in the coming years. (It has $350 million in principal payments scheduled for 2019.) Interest expense reached $34 million last quarter, eating up more than a quarter of SkyWest's operating income, so debt reduction could have a significant positive impact on earnings over time.
SkyWest also spent $110 million to buy out the leases on 52 aircraft last month. This will drive an immediate increase in EPS while improving the company's long-term flexibility. Management indicated that it will pursue additional transactions of this nature.
Finally, SkyWest's strong cash flow should allow it to ramp up share buybacks over the next few years, which would also boost EPS.
Risks to keep in mind
SkyWest executives hinted on the recent earnings call that EPS could come close to $6 this year. Based on SkyWest stock's Monday closing price of $52.35, it is trading for just nine times forward earnings. That's pretty cheap in light of the EPS growth opportunities described above.
That said, there are some risk factors that investors need to be aware of. First, while SkyWest has so far felt no ill effects from a pilot shortage that has impacted other regional airlines, it could be forced to raise pilot pay significantly if the shortage worsens. Second, as SkyWest's E175 fleet ages, maintenance costs are likely to rise significantly. Third, while the E175 is the regional jet of choice today, that could change in a hurry if the legacy carriers ever manage to modify their labor contracts to allow regional airlines to operate next-generation planes like Embraer's E175-E2 or Mitsubishi's MRJ90.
The good news is that SkyWest has a strong balance sheet that will improve rapidly in the next few years as it pays down debt. This should give it the flexibility it needs to succeed regardless of how market conditions evolve going forward.
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